Client Information Series - Social Security, 2015 Tax Law Changes, and the Economy

Thanks to everyone who attended our latest Client Information Seminar; it was great to see everyone again and briefly catch up.  For those of you who were unable to make it, we have you can see Kris and Michelle's videotaped presentations on the videos page.

Michelle Ash, CFP®, CASL® goes through how to maximize Social Security benefits and four separate strategies designed to maximize your income in retirement.

Kris d’Esterhazy, CFP® goes through the latest tax law changes as they pertain to IRAs and other retirement accounts - including a short discussion of the charitable contribution tax break which exists for individuals who wish to directly contribute the required minimum distribution from their IRAs to a qualifying charity.  Also don't miss her discussion on an important change to IRA rollover rules, which eliminate the ability to do multiple 60-day rollovers in any given 12-month period.

During the workshop, I also went over our most recent observations concerning the economy and the markets.  A short synopsis of my presentation follows.

General Economic Observations

Based upon the most current economic information that we have, it is very likely that we are in the "middle phase" of the economic cycle.  This means that we believe we are past the initial stages of post-recession recovery, but not yet into the latter phases of the economic cycle where growth begins to slow, and inflation begins to take hold.  Based upon a roll-up of all of the recession-prediction models that we are monitoring, the odds of a recession developing within the next 6 months or so are very low - less than 10%.

The Fed has all but said that they will raise interest rates later this year; our expectation is that we will begin to see sporadic interest rate increases, probably in the 0.25% range, starting this summer.  While the Fed has stated that they do not want to telegraph their every move, they have also been quite forthcoming about their intentions, and do wish to create a general sense of transparency. 

The fact is that recessions occur every 7-12 years on average, and we are well into the 8th year since the beginning of the last recession.  If the Fed does not raise interest rates at least several percentage points above the present level, then they will have no pages in their playbook when the next recession arrives.  Currently the Fed is all out of bullets, and they need to reload their sixgun, so to speak.

The European Union is slowly scrabbling its way out of its recession, led primarily by Germany.  The US Dollar has strengthened powerfully over the last 6 months - which is very positive for European exporters.  As the dollar becomes more powerful, European goods become cheaper for the largest consumer market in the world - boding well for the companies in Europe selling those goods.  Currently, year-to-date, the international markets are well ahead of the US markets - giving us a little payback for dragging down our returns for the past 12 months.

Stock and Bond Markets 

The US stock markets have shrugged off their recent sideways trading pattern and reached new highs - a good indicator of future movement.  Since, historically, stock market drops solidly greater than 20% occur only during recessions, and given that the odds of a recession are extremely low at present, it makes sense that the most prudent investment strategy would be to have as high an exposure to equities (stocks) as an investor can tolerate. 

Interest rate increases on Bonds:

Increasing interest rates are nothing to fear for most investors.  Historically, the stock market typically does well during interest rate rises.  We only have to look at the markets of 1997-1999, or 2004-2006 to get confirmation of that.  It is only when a recession arises that the stock market predictably struggles again.  The problem currently is in the bond portion of the portfolio.

Existing bond prices rise if interest rates drop, and fall if interest rates rise.  This is because the market has already valued the future cash flows of all existing bonds in the market.  When NEW bonds are issued with higher cash flows (higher interest payments) then all existing bonds become less attractive than they previously were - and worth less.

So... here is the math (greatly simplified, but adequate to generally set reasonable expectations).

Change in Bond Price = (approximately) Change in interest ratex   Duration.

"Duration" is, (very) loosely defined, the average maturity of a bond portfolio.  Without going into too much detail, the current duration of our portfolios is 3.85.

Therefore, if the Fed raises interest rates by 0.25%... then:

Change in price = 0.25% x 3.85 = 0.96%.  This means that with every 0.25% increase in current interest rates, our bond portfolios will likely DROP by about 1%.

However - the bonds still pay interest.  So, the total return on a portfolio would likely be:

Return = Yield (currently 4%) - Change in Price (-1%) or about 3%.  If the Fed raises interest rates .25% per year, then we are likely to return 3% in bonds.  If the Fed raises interest rates 0.5% per year, then we are likely to get 2% in bonds.

So, what will a portfolio with bonds in it return?  This depends upon how MUCH of the portfolio consists of bonds.  Suppose an investor has a standard 60/40 portfolio - with 60% of the portfolio consisting of equities, and 40% consisting of bonds.  If the stock market returns 8%, and their portfolio effectively captures that 8% - and the Bonds return only 2% (as in the example above), then the portfolio is likely to return:

60% of the portfolio gives us 8%, or 8% x .60 = 4.8%

40% of the portfolio gives us 2%, or 2% x .40 = 0.8%

Adding both portions together (4.8% + 0.8%) = 5.6%
Similarly, a more aggressive 75/25 portfolio would likely return 6.5%, and a more conservative 40/60 portfolio would likely return 4.4%.  If the stock market does better - then the portfolio will generate more return; conversely, if the stock market does worse, then the overall returns would be worse than described.

The reason I have gone into such detail here is that I feel it is important for clients to understand that sometimes, in order to achieve necessary growth, building the portfolio so as to generate returns is necessary.  If you are an investor that leans more to a conservative portfolio, it is possible that you will have to take more risk than you are currently in order to generate the returns necessary for your retirement plan to work out as desired.  However - all of the data suggests that IF you must increase your equity exposure - then the current economic environment is likely one of the better times for you to do that, without the fear of a recession-driven market crash.

Should that data change, and the onset of a recession seem imminent - we will take immediate action to protect all client portfolios as is our stated investment protocol.

As always, we appreciate the faith you have in us and allowing us to serve your needs. 

Have a wonderful week and below please check out the video links, at your convenience.

- Jon

UncategorizedJon Castle